What Is the Impact of Reflation on Hedge Fund Performance?

Let’s ensure that we are on the same page before diving into this topic. Reflation, in the context of this article, refers to implementing a government’s fiscal policy and/or a central bank’s monetary policy in a manner that halts or reverses a deflationary trend. A government’s fiscal policy may include, for example, cutting taxes, or making substantial investments in infrastructure projects.

The central bank’s tool kit would include raising/lowering interest rates and, more recently, quantitative easing. Quantitative easing is the large scale purchase of assets, usually bonds, from banks with an eye toward stimulating the economy. Quantitative easing accomplishes this by increasing the money supply, reducing the cost of capital and stimulating investment.

What Is Reflation Supposed to Accomplish?

A reflation policy is intended to alter the trajectory of a deflationary trend in which the prices of goods and services decline. It is important to note that deflation is not synonymous with disinflation, which is defined as a slowing of the rate of inflation.

How Does Reflation Affect Investors?

As stated earlier, reflation may be implemented via the central bank by increasing interest rates. Such increases will cause the price of existing bonds to fall because they will be forced to compete with new bonds issued with higher yields. Many investors will elect to sell older bonds in favor of purchasing new bonds issued with a higher yield. These are actually called reflation trades.

In terms of equities, historical data show that P/E ratios tend to rise as the rate of inflation increases from greater than 1 percent through less than 3 percent. This fact will impact investment decisions for many investors.

What Is the Effect of Reflation for Hedge Funds?

Hedge funds are investors too, and, as such, must be constantly alert to government and central bank policies that impact the markets. This is particularly the case in the era of Trump, as many of the administration’s policies are deflationary in nature, such as tax cuts and the proposed infrastructure expenditures.

One can sympathize with President Trump’s concern regarding the Federal Open Market Committee’s (FOMC) plan for continued interest rate hikes, which, quite literally, would compound the effects on inflation—effects that were already being brought about by the government’s tax cut and administration plans to step up infrastructure spending. Although roundly criticized for interfering with the course FOMC chair Jay (Jerome) Powell had set, President Trump’s concerns were most likely justified.

Allocations are likely to grow as investors recognize the favorable returns occurring in growth assets and analyze risk in terms of opportunity cost.

What about Hedge Fund Jobs?

Hedge funds enjoyed strong gains in January, with a 1.53 percent gain in HFR’s asset weighted composite index. While not as robust a start to the New Year as 2018’s January gain of 2.74 percent, it is a welcome change in comparison to last year’s overall negative performance, which saw the asset weighted composite index close down (-0.84 percent) for the year.